1 chapter 26 - leasing what is a lease? why lease? operating versus financial leases valuing leases...
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1
Chapter 26 - Leasing
• What is a Lease?
• Why Lease?
• Operating versus Financial Leases
• Valuing Leases
• When Do Leases Pay?
2
The Basics– A lease is a contractual agreement between a
lessee and lessor. – The agreement establishes that the lessee
has the right to use an asset and in return must make periodic payments to the lessor.
– The lessor is either the asset’s manufacturer or an independent leasing company.
3
Buying versus Leasing
Buy LeaseFirm U buys asset and uses asset; financed by debt and equity.
Lessor buys asset, Firm U leases it.
Manufacturer of asset
Equity shareholders
Firm U1. Uses asset
2. Owns asset
Creditors
Manufacturer of asset
Lessor1. Owns asset
2. Does not use asset
Equity shareholders Creditors
Lessee (Firm U)1. Uses asset
2. Does not own asset
4
Reasons for Leasing
• Good Reasons– Taxes may be reduced by leasing.– The lease contract may reduce certain types of
uncertainty.– Transactions costs can be higher for buying an
asset and financing it with debt or equity than for leasing the asset.
• Bad Reasons– Leasing and accounting income– 100% financing
5
Operating Leases
• Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor.
• Usually require the lessor to maintain and insure the asset.
• Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.
6
Financial (Capital) Leases
The exact opposite of an operating lease.
1. Do not provide for maintenance or service by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease at expiry.
4. Generally, financial leases cannot be cancelled, i.e., the lessee must make all payments or face the risk of bankruptcy.
7
Sale and Lease-Back
• A particular type of financial lease.• Occurs when a company sells an asset it
already owns to another firm and immediately leases it from them.
• Two sets of cash flows occur:– The lessee receives cash today from the sale.– The lessee agrees to make periodic lease
payments, thereby retaining the use of the asset.
8
Leveraged Leases
• A leveraged lease is another type of financial lease.• A three-sided arrangement between the lessee, the
lessor, and lenders.– The lessor owns the asset and for a fee allows
the lessee to use the asset.– The lessor borrows to partially finance the asset.– The lenders typically use a nonrecourse loan.
This means that the lessor is not obligated to the lender in case of a default by the lessee.
9
Leveraged Leases
Lessor buys asset, Firm U leases it.
Manufacturer of asset
Lessor1. Owns asset
2. Does not use asset
Equity shareholders Creditors
Lessee (Firm U)1. Uses asset
2. Does not own asset
The lenders typically use a nonrecourse loan. This means that the lessor is not obligated to the lender in case of a default by the lessee
Lessor borrows from lender to partially finance purchase
In the event of a default by the lessor, the lender has a first lien on the asset. Also the lease payments are made directly to the lender after a default.
10
Accounting and Leasing
• In the old days, leases led to off-balance-sheet financing.
• In 1979, the Canadian Institute of Chartered Accountants implemented new rules for lease accounting according to which financial leases must be “capitalized.”
• Capital leases appear on the balance sheet—the present value of the lease payments appears on both sides.
11
Accounting and Leasing
Balance Sheet
Truck is purchased with debt
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000
Capital Lease
Assets leased $100,000 Obligations under capital lease $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
12
Financial (Capital) Lease
A lease must be capitalized if any one of the following is met:– The present value of the lease payments is at least
90-percent of the fair market value of the asset at the start of the lease.
– The lease transfers ownership of the property to the lessee by the end of the term of the lease.
– The lease term is 75-percent or more of the estimated economic life of the asset.
– The lessee can buy the asset at a bargain price at expiry.
13
Taxes and Leases• The principal benefit of long-term leasing is tax
reduction.• Leasing allows the transfer of tax benefits from those
who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can.
• If the CRA (Canada Revenue Agency) detects one or more of the following, the lease will be disallowed.
1. The lessee automatically acquires title to the property after payment of a specified amount in the form of rentals.
2. The lessee is required to buy the property from the lessor.
3. The lessee has the right during the lease to acquire the property at a price less than fair market value.
14
Operating LeaseExample : Acme Limo has a client who will sign a lease for 7 years,
with lease payments due at the start of each year. The following table shows the NPV of the limo if Acme purchases the new limo for $75,000 and leases it for 7 years.
Year0 1 2 3 4 5 6
Initial cost -75Maintenance, insurance, selling, -12 -12 -12 -12 -12 -12 -12
and administrative costsTax shield on costs 4.2 4.2 4.2 4.2 4.2 4.2 4.2Depreciation tax shield 0 5.25 8.4 5.04 3.02 3.02 1.51Total -82.8 -2.55 0.6 -2.76 -4.78 -4.78 -6.29
NPV @ 7% = - $98.15
Break even rent(level) 26.18 26.18 26.18 26.18 26.18 26.18 26.18Tax -9.16 -9.16 -9.16 -9.16 -9.16 -9.16 -9.16Break even rent after-tax 17.02 17.02 17.02 17.02 17.02 17.02 17.02
NPV @ 7% = - $98.15
15
Financial LeasesExample : Greymare Bus Lines is considering a lease. Your
operating manager wants to buy a new bus for $100,000. The bus has an 8 year life. The Bus Saleswoman says she will lease Greymare the bus for 8 years at $16,900 per year, but Greymare assumes all operating and maintenance costs.
Should Greymare Buy or Lease the bus?
Year0 1 2 3 4 5 6 7
Cost of new bus 100.00 Lost Depr tax shield (7.00) (11.20) (6.72) (4.03) (4.03) (2.02) - Lease payment (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) Tax shield of lease 5.92 5.92 5.92 5.92 5.92 5.92 5.92 5.92 Cash flow of lease 89.02 (17.98) (22.18) (17.70) (15.01) (15.01) (13.00) (10.98)
Cash flow consequences of the lease contract to Greymare
16
Financial Leases
Example - cont
Greymare Bus Lines can borrow at 10%, thus the value of the lease should be discounted at 6.5% or .10 x (1-.35). The result will tell us if Greymare should lease or buy the bus.
Year0 1 2 3 4 5 6 7
Cost of new bus 100.00 Lost Depr tax shield (7.00) (11.20) (6.72) (4.03) (4.03) (2.02) - Lease payment (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) (16.90) Tax shield of lease 5.92 5.92 5.92 5.92 5.92 5.92 5.92 5.92 Cash flow of lease 89.02 (17.98) (22.18) (17.70) (15.01) (15.01) (13.00) (10.98)
17
Financial Leases
Example – A loan with same cash flows as lease
Year0 1 2 3 4 5 6 7
Amount borrowed at year end 89.72 77.56 60.42 46.64 34.66 21.89 10.31 0.00Interest paid @ 10% -8.97 -7.76 -6.04 -4.66 -3.47 -2.19 -1.03Tax shield @ 35% 3.14 2.71 2.11 1.63 1.21 0.77 0.36Interest paid after tax -5.83 -5.04 -3.93 -3.03 -2.25 -1.42 -0.67Principal repaid -12.15 -17.14 -13.78 -11.99 -12.76 -11.58 -10.31Net cash flow of equivalent loan 89.72 -17.99 -22.19 -17.71 -15.02 -15.02 -13.00 -10.98
18
Financial Leases
Example - cont
The Greymare Bus Lines lease cash flows can also be treated as a favorable financing alternative and valued using APV.
$3,70073,000APV
lease of NPV project of NPVAPV
00
19
Financial Lease Benefits
700$or 70.
1.065
98.10
1.065
13
1.065
02.15
1.065
71.17
1.065
19.22
1.065
17.99-89.02 65432
700$or 70.
1.065
98.10
1.065
13
1.065
02.15
1.065
71.17
1.065
19.22
1.065
17.99-89.02 65432
820$or 82.
18.99100
)10.1(
9.16100
7
0
t
t
820$or 82.
18.99100
)10.1(
9.16100
7
0
t
t
Value of lease to lessor =
Value of lease =
20
Example
• Consider a firm, ClumZee Movers, that wishes to acquire a delivery truck.
• The truck is expected to reduce costs by $4,500 per year.
• The truck costs $25,000 and has a useful life of five years.
• If the firm buys the truck, they will depreciate it straight-line to zero.
• They can lease it for five years from Tiger Leasing with an annual lease payment of $6,250 paid at the end of the year.
• The firm’s borrowing rate is 7.70% and its marginal tax rate is 34%.
21
Example Q1: continue
Suppose ClumZee movers is actually in the 25% tax bracket and Tiger Leasing is in the 35% tax bracket and a before tax borrowing rate of 7%. If Tiger reduces the lease payment to $6,200, can both firms have a positive NPV?
22
Summary
• There are three ways to value a lease.1. Use the real-world convention of discounting the
incremental after-tax cash flows at the lessor’s after-tax rate on secured debt.
2. Calculate the increase in debt capacity by discounting the difference between the cash flows of the purchase and the cash flows of the lease by the after-tax interest rate. The increase in debt capacity from a purchase is compared to the extra outflow at year 0 from a purchase.
3. Use APV (APV = All-Equity Value + Financing NPV)• They all yield the same answer.
23
Practice Question 1
Calculate NPV for lessee and lessor• Cost of machine = $85,000• CCA rate = 30%• Operating costs = $ 10,000 per year maintenance
expense• Lease payments = $53,600 per year• Lessor provides maintenance as a part of the lease
contract.• Cost of debt (rD) = 15%• After-tax cost of debt, rD(1 ‑TC) = 9% • TC = 40% (for both the lessee and the lessor)
24
Practice Question 2
• A noncancellable lease contract lasts for 4 years with payments of $37,000 at the end of each year. The lessee pays maintenance expense under either the lease or buy alternatives. If purchased, the $100,000 asset has a CCA rate of 30%. The before‑tax cost of debt is 10% and the corporate tax rate is 40%. What is the value of the lease to the lessee?
• If the lease in problem were cancelable, how much must the cancellation option be worth to make the lease alternative better than the purchase alternative?
25
Chapter 26 - Hedging
• Why Manage Risk?
• Insurance
• Forward and Futures Contracts
• SWAPS
• How to Set Up A Hedge
26
Risk Reduction
Why risk reduction does not add value
1. Hedging is a zero sum game
2. Investors’ do-it-yourself alternative
27
Risk Reduction
Risks to a business
1. Cash shortfalls
2. Financial distress
3. Agency costs
28
Insurance
• Most businesses face the possibility of a hazard that can bankrupt the company in an instant.
• Insurance companies have some advantages in bearing risk.
• The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk.
29
Insurance
ExampleAn offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.
How can the cost of this hazard be shared?
30
Insurance
What do you expect the premium of an insurance contract on this oil platform to be?
Think of the following:– Administrative costs– Adverse selection– Moral hazard
31
Insurance – Catastrophe Risk
• The loss of an oil platform by a storm may be 1 in 10,000. The risk, however, is larger for an insurance company since all the platforms in the same area may be insured, thus if a storm damages one it may damage all in the same area. The result is a much larger risk to the insurer
• Catastrophe Bonds - (CAT Bonds) Allow insurers to transfer their risk to bond holders by selling bonds whose cash flow payments depend on the level of insurable losses NOT occurring.
32
Insurance – What to Insure
Two Possibilities:• Most Common - buy insurance only for large
potential losses. • BP case – buy insurance for small risks only.
33
Hedging with Forwards and Futures
Business has risk
Business Risk - variable costs
Financial Risk - Interest rate changes
Goal - Eliminate risk
HOW?
Hedging & Forward Contracts
34
Hedging with Forwards and FuturesEx - Kellogg produces cereal. A major component and cost
factor is sugar. • Forecasted income & sales volume is set by using a fixed
selling price.• Changes in cost can impact these forecasts.• To fix your sugar costs, you would ideally like to purchase
all your sugar today, since you like today’s price, and made your forecasts based on it. But, you can not.
• You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today.
• This contract is called a “Futures Contract.”• This technique of managing your sugar costs is called
“Hedging.”
35
Hedging with Forwards and Futures1- Spot Contract - A contract for immediate sale &
delivery of an asset.
2- Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future.
3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract.
The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & “provides” a secondary market for the speculation of Futures.
36
Types of Futures
Commodity Futures
-Sugar -Corn -OJ
-Wheat -Soy beans -Pork bellies
Financial Futures
-Tbills -Yen -GNMA
-Stocks -Eurodollars
Index Futures
-S&P 500 -Value Line Index
-Vanguard Index
Futures Contract Concepts
• Not an actual sale• Always a winner & a loser (unlike stocks)• “Settled” every day. (Marked to Market)• Hedge - used to eliminate risk by locking in
prices• Speculation - used to gamble• Margin - not a sale - post partial amount
38
Futures and Spot Contracts
yieldDividend
rate freeRisk
pricespot sToday'
length t ofcontract on price futures
)1(
0
0
y
r
S
F
yrSF
f
t
tft
yieldDividend
rate freeRisk
pricespot sToday'
length t ofcontract on price futures
)1(
0
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r
S
F
yrSF
f
t
tft
The basic relationship between futures prices and spot prices for equity securities.
39
Futures and Spot ContractsExample
The DAX spot price is 3,970.22. The interest rate is 3.5% and the dividend yield on the DAX index is 2.0%. What is the expected price of the 6 month DAX futures contract?
40
Futures and Spot Contracts
yield eConvenienc Netsccyncy
cost storageExpersssc
yield eConvenienccy
rate free Riskr
price spotsToday'S
length t of contract on price futuresF
cyscrSF
f
t
tft
0
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yield eConvenienc Netsccyncy
cost storageExpersssc
yield eConvenienccy
rate free Riskr
price spotsToday'S
length t of contract on price futuresF
cyscrSF
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The basic relationship between futures prices and spot prices for commodities.
41
Futures and Spot ContractsExample
In July the spot price for coffee was $.7310 per pound. The interest rate was 1.5% per (1.3% per 10 months). The 10 month futures price was $0.8285? What is the net convenience yield?
42
Homemade Forward Rate Contracts
Year 0 Year 1 Year 2
Borrow for 1 year at 10% +90.91 -100Lend for 2 years at 12% -90.91 114.04Net cash flow 0 -100 114.04
Year 0 Year 1 Year 2
Borrow for 1 year at 10% +90.91 -100Lend for 2 years at 12% -90.91 114.04Net cash flow 0 -100 114.04
Suppose you know that you will receive $100m in one year. You are worried that interest rates might go down?
You can enter a FRA (forward rate agreement) with a bank.
43
Swaps
0 1 2 3 4 5
1. Borrow $66.67 at 6% fixed rate 66.67 -4 -4 -4 -4 -70.67
2. Lend $66.67 at LIBOR floating rate -66.67 .05x66.67 LIBOR1 x66.67 LIBOR2x66.67 LIBOR3x66.67
LIBOR4x66.67+66.67
Net cash flow 0 -4 -4 -4 -4 -4
.05x66.67 LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67
Standard fixed-to-floating swap 0 -4 -4 -4 -4 -4
.05x66.67 LIBOR1x66.67 LIBOR2x66.67 LIBOR3x66.67 LIBOR4x66.67
Year
Friendly Bancorp invested $50 M in debt carrying 8% fixed interest rate and maturing in 5 years. Annual payments are $4m. However, friendly Bancorp is predicting increases in interest rates, so it wants a floating rate. Here is what it can do.
SWAPS
Birth 1981
Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principal
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How to Set a Hedge?
• In practice, the commodity that a firm sells is likely not identical to the one traded on the exchange.
• Delta measures the sensitivity of A to changes in the value of B.
• Duration is also used in setting hedge. (if two assets have the exact duration, they will be equally affected by change in interest rates).
Ex - Settlement & SpeculateExample - You are speculating in Hog Futures. You think
that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures (1K is of $30,000 pound). If the price drops .17 cents per pound ($.0017) what is total change in your position?
Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price (hedge).
Show the transactions if the Sept spot price drops to $2.80.
Show the transactions if the Sept spot price rises to $3.05.
Commodity Speculation
You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncured bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?
If In Feb the price drops to 40.0 cents, what is your gain/loss?
Margin
• The amount (percentage) of a Futures Contract Value that must be on deposit with a broker.
• Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin.
• CME margin requirements are 15%• Thus, you can control $100,000 of assets
with only $15,000.
50
Chapter 32 - Mergers
• Sensible Motives for Mergers
• Some Dubious Reasons for Mergers
• Estimating Merger Gains and Costs
• The Mechanics of a Merger
• Takeover Battles and Tactics
• Mergers and the Economy
51
The Basic Forms of Acquisitions
• There are three basic legal procedures that one firm can use to acquire another firm:– Merger (or consolidation)– Acquisition of Stock– Acquisition of Assets
• Although these forms are different from a legal standpoint, the financial press frequently does not distinguish among them.
• In our discussions, we use the term merger regardless of the actual form of the acquisition.
52
Merger or Consolidation
• A merger refers to the absorption of one firm by another. The acquiring firm retains its name and identity, and acquires all the assets and liabilities of the acquired firm. After the merger, the acquired firm ceases to exist as a separate entity.
• A consolidation is the same as a merger except that an entirely new firm is created. In a consolidation, both the acquiring firm and the acquired firm terminate their previous legal existence.
53
Acquisition of Stock
• A firm can acquire another firm by purchasing target firm’s voting stock in exchange for cash, shares of stock, or other securities.
• A tender offer is a public offer to buy shares made by one firm directly to the shareholders of another firm.– If the shareholders choose to accept the offer, they
tender their shares by exchanging them for cash or securities.
– A tender offer is frequently contingent on the bidder’s obtaining some percentage of the total voting shares.
– If not enough shares are tendered, then the offer might be withdrawn or reformulated.
54
Acquisition of Assets
• One firm can acquire another by buying all of its assets.• A formal vote of the shareholders of the selling firm is
required.• Advantage of this approach: it avoids the potential
problem of having minority shareholders that may occur in an acquisition of stock.
• Disadvantage of this approach: it involves a costly legal process of transferring title.
55
A Classification Scheme
Financial analysts typically classify acquisitions into three types:– Horizontal acquisition: when the acquirer and
the target are in the same industry.– Vertical acquisition: when the acquirer and the
target are at different stages of the production process; example: an airline company acquiring a travel agency.
– Conglomerate acquisition: the acquirer and the target are not related to each other.
56
Recent Mergers in Canada
Date Amount ($M) Target Acquiring
June 2002 6,320 Bell Canada BCE Inc.
Jan 2002 8,000 Canada Trust TD Bank
Jan 2002 9,203 PanCanadian Energy Alberta Energy
57
Sensible Reasons for Mergers
Economies of Scale
A larger firm may be able to reduce its per unit cost by using excess capacity or spreading fixed costs across more units.
$ $$Reduces costsReduces costs
58
Sensible Reasons for Mergers
Combining Complementary ResourcesMerging may results in each firm filling in the “missing pieces” of their firm with pieces from the other firm.
Firm A
Firm B
59
Sensible Reasons for Mergers
Mergers as a Use for Surplus Funds
If your firm is in a mature industry with few, if any, positive NPV projects available, acquisition may be the best use of your funds.
60
Source of Synergy from Acquisitions
• Revenue Enhancement• Cost Reduction
– Including replacement of ineffective managers.• Tax Gains
– Net Operating Losses– Unused Debt Capacity
• Incremental new investment required in working capital and fixed assets
61
Dubious Reasons for Mergers
• Diversification– Investors should not pay a premium for
diversification since they can do it themselves.
62
Dubious Reasons for Mergers
The Bootstrap GameAcquiring Firm has high P/E ratio
Selling firm has low P/E ratio (due to low number of shares)
After merger, acquiring firm has short term EPS rise
Long term, acquirer will have slower than normal EPS growth due to share dilution.
63
Dubious Reasons for Mergers
The Bootstrap Game
World Enterprises (before merger) Muck and Slurry
World Enterprises (after buying Muck
and Slurry)
EPS 2.00$ 2.00$ 2.67$ Price per share 40.00$ 20.00$ 40.00$ P/E Ratio 20 10 15Number of shares 100,000 100,000 150,000 Total earnings 200,000$ 200,000$ 400,000$ Total market value 4,000,000$ 2,000,000$ 6,000,000$
Current earnings per dollar invested in stock 0.05$ 0.10$ 0.067$
64
Dubious Reasons for Mergers
Earnings per dollar invested
(log scale)
NowTime
.10
.067
.05
Muck & Slurry
World Enterprises (before merger)
World Enterprises (after merger)
65
Lower Financing Costs
The combined company can borrow at lower interest rates than either firm could separately.
That is what we would expect in well functioning markets, but it does not increase value for shareholders
66
Estimating Merger Gains
• Questions– Is there an overall economic gain to the
merger?– Do the terms of the merger make the
company and its shareholders better off?
PV(AB) > PV(A) + PV(B)
67
Estimating Merger Gains
)(
cos)(
)(
BAB
B
ABBAAB
PVcashPV
tgainANPV
PVpaid CashCost
PVPVPVPVGain
68
Estimating Merger Gains
25$
50$
200$
AB
B
A
PVGain
PV
PV
Example – Two firms merge creating $25 million in synergies. A pays B a sum of $65 million.
69
Estimating Merger Gains
Look at Incremental Economic Gain
Economic Gain = PV(increased earnings)
= New cash flows from synergies
discount rate
70
Cash versus Common Stock Acquistion
• Estimating Cost with Stock
• Taxes– Cash acquisitions usually trigger taxes.– Stock acquisitions are usually tax-free.
• Sharing Gains from the Merger– With a cash transaction, the target firm
shareholders are not entitled to any downstream synergies.
71
The Tax Forms of Acquisitions
• In a taxable acquisition (cash offer), the shareholders of the target firm are considered to have sold their shares, and they will have capital gain/losses that will be taxed.
• In a tax-free acquisition, since the acquisition is considered an exchange instead of a sale, no capital gain or loss occurs.
72
Tax Consequences of a Merger
Taxable Merger Tax-free Merger
Impact on Captain BCaptain B must recognize a
$30000 capital gain and recapture depreciation $130,000.
Capital gain can be deferred until Captain B sells the Baycorp
shares.
Impact on baycorp
Boat is revalued at $280000. Tax depreciation increases to
$280000/10=$28000 per year (assuming 10 years of remaining
life)
Boat's value remains at $150000, and tax depreciation continues
at $15000 per year.
In 1995 Seacorp (fully owned by Captain B) purchases a boat for $300,000. In 2005, the boat’s book value is $150,000, but its market value is $280,000. In 2005 Seacorp also holds $50,000 of marketable securities so its market value is $330,000.
Suppose Baycorp acquires Seacorp for $330,000.
73
Defensive Tactics
• Target-firm managers frequently resist takeover attempts.
• It can start with press releases and mailings to shareholders that present management’s viewpoint and escalate to legal action.
• Management resistance may represent the pursuit of self interest at the expense of shareholders.
• Resistance may benefit shareholders in the end if it results in a higher offer premium from the bidding firm or another bidder.
74
Takeover Defenses TerminologyWhite Knight - Friendly potential acquirer sought by the target
company’s management. The white knight promises to maintain the jobs of existing management and helps to threaten an unwelcome suitor.
Shark Repellent - Amendments to a company charter made to forestall takeover attempts.
Poison Pill - Measure taken by a target firm to avoid acquisition; for example, the right for existing shareholders to buy additional shares at an attractive price if a bidder acquires a large holding.
Golden parachutes - are compensation to outgoing target firm management.
Crown jewels - are the major assets of the target. If the target firm management is desperate enough, they will sell off the crown jewels.
75
The Control Block and Anti-Takeover Legislation
• If one individual or group owns 51-percent of a company’s stock, this control block makes a hostile takeover virtually impossible.
• Control blocks are typical in Canada, although they are the exception in the United States.
• In the US, however, anti-takeover legislation has received wide attention.
76
Exclusionary Offers and Nonvoting Stock
The target firm makes a tender offer for its own stock while excluding targeted shareholders.
An example:– In 1986, the Canadian Tire Dealers
Association offered to buy 49% of the company’s voting shares from the founding Billes family.
– The offer was voided by the OSC, since it was viewed as an illegal form of discrimination against one group of shareholders.
77
Going Private and LBOs
• If the existing management buys the firm from the shareholders and takes it private.
• If it is financed with a lot of debt, it is a leveraged buyout (LBO).
• The extra debt provides a tax deduction for the new owners, while at the same time turning the previous managers into owners.
• This reduces the agency costs of equity as managers are now also owners.
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Abnormal Returns in Successful Canadian Mergers
Target Bidder
Mergers 1964--83 9% 3%
Going private
Transactions 1977--89 25% NA
- Minority buyouts 27% NA
- Non-controlling bidder 24% NA
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Comparison of U.S. vs. Canadian Mergers
• The evidence both in U.S. and Canada strongly suggests that shareholders of successful target firms achieve substantial gains from takeovers.
• Shareholders of bidding firms earn significantly less from takeovers. The balance is more even for Canadian mergers than for U.S. ones.
One possible reason:– There is less competition among bidders in Canada.
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Divestitures
• The basic idea is to increase corporate focus.• Divestiture can take three forms:
– Sale of assets: usually for cash– Spinoff: parent company distributes shares of a
subsidiary to shareholders. Shareholders wind up owning shares in two firms. Sometimes this is done with a public IPO.
– Issuance if tracking stock: a class of common stock whose value is connected to the performance of a particular segment of the parent company.
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Summary and Conclusions
• The three legal forms of acquisition are1. Merger and consolidation
2. Acquisition of stock
3. Acquisition of assets
• M&A requires an understanding of complicated tax and accounting rules.
• The synergy from a merger is the value of the combined firm less the value of the two firms as separate entities.
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Summary and Conclusions
• The possible synergies of an acquisition come from the following:– Revenue enhancement– Cost reduction– Lower taxes– Lower cost of capital
• The reduction in risk may actually help existing bondholders at the expense of shareholders.
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Practice Q1
Suppose Todd Trucking Company's stock is trading for $50 a share while Hamilton Company's stock goes for $25 a share. The EPS of Todd is $1 while the EPS of Hamilton is $2.50. Neither company has debt in its current capital structure. Both companies have one million shares of stock outstanding.
a. If Todd can acquire Hamilton for stock in an exchange based on market value, what should be the post‑merger EPS?
b. Suppose Todd pays a premium of 20% in excess of Hamilton's current market value. How many shares of Todd must be given to Hamilton's shareholders for each of their shares?
c. Based on your results in b, what will Todd's EPS be after it acquires Hamilton?
d. If Hamilton were to acquire Todd by offering a 20% premium in excess of Todd's current market price, how many shares of stock would Hamilton have to offer, and what would be the effect on Hamilton's EPS?
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Practice Q2
Susie's Pizza is analyzing the possible acquisition of Janet's Electric. The projected cash flows to debt and equity expected from the merger are as follows:Year(s) CF
1 150,0002 170,0003 200,0004 200,0005 on 6% growth per year
The current market price of Janet's debt is $800,000, the risk‑free rate is 8%, the required return on the market is 12%, and the beta of the firm being acquired is 1.5.
a. Determine the maximum price (NPV) Susie can afford to pay.b. If Janet's current equity value is $1,100,000 and she demands a
30% premium, will the merger take place?